While the stock market soared and investors returned to US equities, 2013 was also a banner year for alternatives (private equity, hedge funds, real estate, and others) as both institutional investors and retail investors became more eager to take advantage of what had been niche strategies in the recent past.

Alternatives

But part of the reason alternatives have a much broader appeal is because the driving force behind investors allocating assets to them has also changed.

“The ‘wow moment’ in our paper for 2013 was the rationale for investing in those types of asset structures and asset classes,” says BNY Mellon head of global risk solutions Debra Baker. “In 2005, the number one reason was to gain alpha. It was growth. It was getting return. And now, we asked that same question in 2013, and the number one reason for moving into those structures was for diversification benefits.”

In a survey conducted with Nobel Prize-winning economist Harry Markowitz, Baker found that investors have taken to heart one of the main lessons of the global crisis – that it’s important to diversify a portfolio along underlying risk factors, not just among different sectors. Since virtually any basket of stocks will have some correlation with risk, it’s important to branch out into different types of assets to protect from future downturns.

Markowitz emphasizes operations research

“I think we will use more operations research,” says Markowitz. “We’re gonna have a shift towards the operations research, the big data, the simulation, and the databases, and away from the stylized economic models.”

As the inventor of modern portfolio theory, the emphasis on quantitatively rigorous practices over investment styles like value investing or momentum strategies isn’t surprising. One of the early criticisms of Markowitz’s theory was simply that it was so data and computationally intensive that it wasn’t realistic for everyone to implement, but that’s clearly changing. The reason Big Data has so many people excited (not just in finance) is that we now have the exact opposite problem: easy access to so much data that it’s easy to feel overwhelmed.

Markowitz still skeptical of alternatives

While Markowitz is willing to include alternatives in his analysis of efficient portfolios, and he recognizes the reason they are growing in prominence, he isn’t convinced that they will deliver as promised.

“The people selling these products claim they have higher expected returns and lower correlations and volatilities than traditional investments,” said Markowitz, reports Kris Devasabai on Risk.net. “But if you dig deeper, you’ll find that isn’t really true in most cases.”